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U.S. Bonds Offering Relatively Good Value

Yields considerably higher for U.S. government bonds than for U.K. gilts, and Treasuries are cheapest in 23 years vs. German bunds.

The longest decline in Treasuries this year has left U.S. government debt the cheapest since March 2011 when measured by real yields—and the best relative value, compared with German bunds, in more than two decades.

After inflation, 10-year U.S. notes yielded 0.91 percent last week, or 1.77 percentage points more than real yields on U.K. gilts, the widest spread in 25 months. Versus Germany, the securities are the least costly in 23 years when adjusted for the recent record-low interest rates around the world that distorted the normal relationship, according to FTN Financial.

Federal Reserve Chairman Ben S. Bernanke is counting on Treasuries to contain borrowing costs as the central bank buys $85 billion a month in securities to sustain the economic recovery that lifted U.S. consumer confidence to the highest in almost six years. The better relative yield for U.S. bonds may help bolster demand even as Warren Buffett said this month that he pitied fixed-income investors because of nearly record-low interest rates.

“The Treasury market is cheaper than almost any other comparable market on a relative value basis,” Jim Vogel, an interest-rate strategist at FTN, said by phone May 15. “There is the thought out there that Treasuries are expensive when in reality they offer the most value given the improving economy and the relative real yield they offer compared to others.”

The Memphis, Tennessee-based firm has correctly been less bearish on bonds than consensus forecasts for the past two years. In May 2012, the firm’s chief economist, Christopher Low, said 10-year yields would fall to 1.5 percent from a then-1.79 percent. They hit that mark three weeks later, and fell as low as 1.38 percent in July. The rate fell three basis points to 1.92 percent as of 9:38 a.m. in New York.

Treasuries due in at least 10 years were yielding 40 basis points more than non-U.S. sovereign debt on May 16, according to Bank of America Merrill Lynch indexes. As recently as September, U.S. rates were lower than those for the rest of the world.

While yields on 10-year Treasuries rose to 1.95 percent last week, below the average of about 5 percent since 1990, they are 60 basis points, or 0.6 percentage point, higher than similar-maturity German bunds. That’s about double the average since 2003. They are five basis points more than gilts, versus an average of about 30 basis points below over the same period.

Easy Ownership

“As expensive as Treasuries are, if you compare them to other developed markets, it makes it easier to own them,” Raman Srivastava, the head of global fixed income at Boston-based Standish Mellon Asset Management Company LLC, which manages $170 billion, said in a telephone interview on May 15.

In FTN’s analysis, which adjusts for today’s record low interest rates around the world as monetary policies from the U.S., euro zone, the U.K., and Bank of Japan converge to give a more-accurate reading of relative value, Treasuries are about 30 percent cheaper than average, according to Vogel.

Treasury 10-year notes fell in each of the past three weeks, the longest stretch since December. Yields have risen from 1.66 percent on April 26 amid reports showing gains in jobs and consumer confidence. The price of the benchmark 1.75 percent security due May 2023 declined 15/32 last week, or $4.69 per $1,000 face amount, to 98 5/32, Bloomberg Bond Trader data show.

Savers dependent on bond payments are “victims” of central bank policies to lower borrowing costs, Buffett, the chief executive officer of Berkshire Hathaway Inc., said at the company’s annual shareholder’s meeting in Omaha, Nebraska, May 4.

“I feel sorry for people that have clung to fixed-dollar investments,” he said.

Bill Gross, who runs the world’s biggest bond fund for Pacific Investment Management Co. in Newport Beach, California, said in an interview on Bloomberg Television May 16 that the three-decade bull market for bonds “was over.”

He still increased Treasuries to 39 percent of his $293 billion Total Return Fund in April, the highest level since July 2010. Treasuries, for now, “are a better alternative than cash,” he wrote in a May 1 investment outlook.

Treasuries have lost 0.33 percent this year, including reinvested interest, compared with 0.93 percent for the global sovereign bond market, Bank of America Merrill Lynch indexes show. The MSCI All-Country World Index of equities has risen 7.5 percent this year, and corporate bonds have returned 2.08 percent as measured by Bank of America Merrill Lynch Indices.

Bond Overreaction

Three Federal Reserve regional bank presidents, Richard Fischer of Dallas, Charles Plosser of Philadelphia, and Jeffrey Lacker of Richmond, called last week for the central bank to phase out the $40 billion monthly purchases of mortgage-backed securities. It’s also buying $45 billion of Treasuries a month.

“The market has overreacted to the tapering signals from a Fed that is still on hold for some time, and inflation fundamentals globally and domestically are still weak,” Michael Pond, head of global inflation-linked research in New York at Barclays Plc, said in a phone interview on May 15. Treasuries are “attractive on a relative basis,” he said.

Gross domestic product may grow by 2 percent in 2013, down from 2.2 percent last year and the 2.7 percent posted in 2006 before the recession and worst financial crisis since the Great Depression, according to the median estimate of more than 80 economists surveyed by Bloomberg.

Growth globally is also depressed, with Japan forecast to expand 1.4 percent the euro region to contract 0.5 percent, according to separate Bloomberg surveys of economists.

Auction Demand

Evidence of bond demand can also be seen in the government’s debt auctions. The Treasury’s $777 billion in bond sales this year have attracted an average of $3 in orders per dollar sold, making this the third-strongest year ever and compared with the record $3.15 in 2012, according to data released by the Treasury and compiled by Bloomberg.

“It doesn’t look like a great big bond market sell-off is coming anytime soon,” Jack McIntyre, a money manager who oversees $44.5 billion for Brandywine Global Investment Management LLC in Philadelphia, said in a May 16 telephone interview. “At the end of the day growth is still mixed, inflation is fairly tame, and the Fed’s foot is still on the easing pedal.”

Treasury returns are enhanced by the slowdown in inflation. The consumer price index in the U.S. fell 0.4 percent in April following a 0.2 percent decrease in March, the first back-to-back declines since 2008, according to the Labor Department.

Falling commodity prices are weighing on inflation. The Standard & Poor’s GSCI Total Return Index of 24 raw materials has declined 8.6 percent from this year’s peak in February.

For international investors, a rising dollar also has the potential to boost returns from Treasuries. For yen-based investors, this year’s losses in U.S. bonds would translate into a gain of 18.7 percent after currency conversions.

IntercontinentalExchange Inc.’s U.S. Dollar Index rose to 84.371 on May 17, the highest level since July 2010.

“A stronger dollar weighs on commodity prices and thus inflation,” said Richard Gilhooly, an interest-rate strategist at TD Securities Inc. in New York. “What is negative for inflation is a positive for Treasuries, especially given the U.S. real yield differential against everyone else.”

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